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Friday, 18 January 2013

Government debt isn't what you think it is

Government debt is not debt in any meaningful sense of the word.

Well, actually that's not quite true. Let me clarify. The debt of genuinely sovereign governments that issue their own currencies, have properly functioning central banks and full control of monetary policy is not debt in any meaningful sense of the word.

This all stems from the nature of our fiat money system. In a fiat money system, governments create money. More accurately, money is created by private banks as agents of the state, backed and supported by the central bank which is part of government. The "independence" of central banks is pure fiction. Central banks may operate independently of political control - if politicians allow them to - but they are part of the government machine just as much as government treasury departments are.

Most central banks - with the notable exception of the Federal Reserves - were originally created to fund governments, but their role has changed over the centuries and we have now reached the interesting position where central banks are not allowed to fund governments directly, though they can and do fund them indirectly via the banking system. But there is no reason under a fiat money system why a sovereign government could not simply instruct its central bank to issue money to meet spending commitments, rather than issuing debt. When governments do this it is known as monetization, or "printing money" - although these days not much printing would be involved. It is NOT the same as QE, which exchanges various forms of government debt for money.

Monetization has historically been associated with hyperinflation, and it is fair to say that the fear of inflation is the principal reason why governments don't simply issue money to meet spending commitments. But leaving aside voluntary (and sometimes legal) constraints on monetization, sovereign governments that issue their own currencies do not need to borrow to meet spending commitments.

So if government could in theory meet its spending commitments entirely through money issuance, why do we need government debt at all? Many people would argue that we don't. But I disagree. You see, debt serves a useful purpose which money does not adequately meet because of its primary function as a medium of exchange.

In the past, when governments did not have control of their own currencies because they were tied to gold, governments had to borrow to fund their spending, because they could not simply issue money. And those countries that today don't have control of their own currencies also have to borrow. So for Eurozone countries - including the mighty Germany - debt is indeed debt. They cannot issue their own currencies, and therefore they have to borrow to meet spending commitments. But for everyone else, debt is not debt, it is savings. The trouble is that we have not yet really understood the nature of our fiat money system. We are still trying to treat it like a gold standard. Thus we insist that governments must borrow to meet spending commitments. And if they borrow what we consider "too much", we start to worry about over-commitment and the debt burden on future generations and the cost of interest service and what on earth the markets will think and will people stop buying our debt and oh my goodness we had better cut back and get this deficit under control. This panic spiral is completely unnecessary and in my view stems from a fundamental misunderstanding of the role of government debt in a fiat money system.

Debt provides a safe store of value for the citizens of the country. It is similar to insured deposits at banks. Like deposits, debt is interest-bearing. And at the moment, debt benefits from a 100% guarantee from government, whereas the insurance on deposits is capped. It is also highly liquid, and therefore the funds are rather more accessible than they are in many time deposit accounts. Debt is also fully transferrable: you can give your son gilts for his 21st birthday, but you can't give him a deposit account. Well, actually, you can if you are a UK resident. You could open a National Savings account in his name, deposit funds in it and give him a National Savings certificate of deposit representing those funds. You would have done EXACTLY the same as buying him gilts to the same value. Effectively, gilts are certificates of deposit. When you buy government securities, you are depositing your money in a 100% government-insured interest-bearing deposit account. Governments really are banks.

But what about the interest on debt? Well, it used to be that government securities were interest-bearing whereas money was not, and this reflected the slightly higher risk of debt. This is because unlike money, debt is time-limited: when it matures it has to be redeemed or refinanced, and there is always the risk that government won't be able to find the money to do that. Or at least that's what people think. They are wrong, of course: sovereign currency-issuing governments can ALWAYS find the money to refinance their debts, because they can issue it. There is effectively zero duration risk on the debt of sovereign currency-issuing governments.

But now that banks pay interest on government-insured deposit accounts, and central banks pay interest on excess reserves, most money is interest-bearing. And interest rates on government debt for highly-regarded currency-issuing sovereigns are at an all-time low. As I've noted before, the liquid nature of government debt means that any real difference between the interest rates on deposits and the yields on debt is arbitraged away. Therefore the interest cost of money and debt are pretty much the same. Governments are free to choose which to issue depending on the saving versus spending needs of the economy.

At present, when the preference is for saving over spending and this has caused a nasty drop in aggregate demand, arguably the preference should be for issuing money rather than debt, since money is the medium of exchange in the real economy and we wish to encourage spending - though of course as money is also an interest-bearing safe asset, adding money may just encourage people to stash it away if their preference is to save. But when the problem is too much spending and government wishes to encourage saving, government may choose to issue more debt and less money, which reduces the money stock in the real economy while maintaining liquidity in the financial system (since interest-bearing money and government debt are near-substitutes). It's a balance. Note that this dynamic balancing of monetary and fiscal instruments requires cooperation of central bank and treasury. It is not possible for them genuinely to be independent of each other for this to work, though if the central bank is responsible for inflation targeting it would probably be sensible for it to be in the driving seat. Perhaps it is time to recognise that the central bank needs to have the right to TELL the Treasury to issue debt!

Note also that I am still not talking about QE. No asset purchases are involved. The money is what Friedman called "helicopter money" - money issued by the central bank and spent directly into the economy. And on the Treasury side, debt should similarly be issued primarily to residents, not to foreigners. This is because of the nature of interest on debt.

Most people who call for government to stop issuing debt - whether because they want government to meet spending commitments through money issuance, or simply want a severe fiscal contraction to "get the deficit under control" - do so because they believe that the interest payments are a deadweight cost. They are wrong. When government debt is held by residents, interest paid is not a cost. It is a tax credit - and if government wanted to, it could recover that by imposition of offsetting taxes.

So ideally, a sovereign currency-issuing government meets its spending commitments by issuing both money, which is used as the medium of exchange in the real economy, AND sufficient interest-bearing debt of various tenors to enable its citizens to save safely in something other than the medium of exchange. It pays interest on that debt from tax receipts, and it taxes away any interest tax credits that it doesn't want certain people (say high earners) to receive. So far, so good. It's a lovely closed system, and provided government is responsible it should not be inflationary. Where it all goes wrong is when foreigners get involved. Because that's when safe government debt becomes risky, and maintaining it, a cost.

Foreign holders of government debt have no direct stay in the way governments manage their economies. They have no vote. So for them the fact that they have no control means risk. The citizens of the country could elect a government that repudiates overseas holdings of its debt or manages the economy so ineptly that the value of the debt is eroded. Therefore foreign debt holders use indirect means of influencing the way governments manage their economies. They demand fiscal austerity measures to hold down government spending for fear of default, and rejection of monetization for fear of inflation. And they threaten to sell their holdings if governments don't comply. For governments who do not issue their currencies, this is a real problem - as we are seeing in the Eurozone. If they can't raise enough from tax income to meet their spending commitments, a buyer's strike can cause them to go bust. But this can't happen to a sovereign currency-issuing government, because it can always print money to pay its debts or buy them back. The threat is empty - but we all still listen to it. How often to we hear people saying that the UK must get its debt under control or it will end up like Greece? No it won't . The UK has a central bank and its own currency. Greece doesn't. That is why Greece really can go bust and the UK can't. That's not to say that the UK can't have serious economic problems, and I am certainly not advocating fiscal profligacy. But for currency issuers the risk is inflation, not insolvency.

In addition to dilution of fiscal and monetary control, foreign holdings of debt cause another problem. Interest paid to foreign debt-holders is a real cost - it leaves the domestic economy. Yes, it comes back eventually in the form of export purchases, but that can take years. In the meantime, it is not available for productive investment in the issuing country. And because it is paid from tax receipts, it is a fiscal transfer from domestic taxpayers to foreign residents. The more government debt is held by foreigners, the less real control it has of fiscal and monetary policy and the greater the real cost to taxpayers.

So why do currency-issuing governments issue debt to foreigners at all? The simple answer is: trade. Overseas residents need foreign currency in order to purchase exports, but just like domestic residents, they prefer to hold their foreign currency savings as something other than the medium of exchange - and indeed if they don't there can be problems with liquidity in international trade finance. So there does need to be some "leakage" of government debt to overseas residents. Problems arise when the holdings of government debt by overseas residents overwhelm the ability of the national economy to support them, and the interests of overseas residents trump those of national citizens. To my mind this is a dangerous imbalance which can lead to all manner of dysfunctional economic policies and eventually to nationalism, balkanisation and political unrest. We do not know what level of overseas holdings of government debt creates this imbalance, but it is notable that Japan, which has the highest debt/GDP level in the world yet is widely regarded as a "safe haven" for investment, has very low foreign holdings of its debt. The vast majority is owned by its own citizens.

This brings me neatly back to that safe asset proposal that I've been talking about recently. Since the failure of private sector "safe" assets in 2008 and the subsequent failure of Eurozone "safe" sovereign debt, the financial system has relied on the debt of sovereign currency-issuing governments for collateral and safe investments. But there is a serious shortage of safe government debt. I've argued already that it is unreasonable to expect one or two countries to provide sufficient safe assets for the entire global financial system. The unequal burden of producing sufficient safe assets for the entire system would eventually overwhelm them. But why should governments provide safe assets for this system at all?

Keeping the global financial system going is essential for the smooth operation of international trade. There is much the global financial system does that is self-serving and, to quote Adair Turner, "socially useless". But not everything is, and to the extent that safe collateral and liquidity are needed to support trade finance and capital flows, it would be reasonable for governments to provide these as a last resort. I don't think it should be a first resort, though. The quest for absolute safety is doomed to fail and is a distraction from the real purpose of investment, which is to finance the productive development of the real economy. The financial sector should try a lot harder to produce assets that, while not completely safe, are acceptable as collateral with a reasonable haircut. And governments and regulators should rethink regulatory rules that increase demands for sovereign debt by global banks and investors. But above all, investors need to come out of their bunkers and start accepting risk. Until they do, the world will be stuck in a deflationary slump.

I'm also adding a link to a subsequent post in which I address concerns that I did not discuss taxation in this post and so (according to some) gave the impression that governments can simply issue unlimited money without consequences. They can't. And as debt is simply a future money claim, that means they can't issue unlimited debt either.

I haven't finished with this subject by any means. There will be further posts on external borrowing constraints and the role of currency, the equivalence of monetary and fiscal policy, and supranational safe assets. That's all I've thought of so far but there will no doubt be others.

When a foreign holder gets their coupon payments in sterling, they are faced with two choices. They can either buy other sterling assets or reduce their sterling exposure through a currency exchange. That leaves one foreign holder less exposed to sterling but on a net basis the rest of the world has the same sterling exposure. The ROW sterling exposure is a consequence of our current account deficit. Therefore, the only way the ROW can reduce their net sterling exposure is through selling less stuff to us. Note how different it is in the EZ, the ROW can reduce their Greek, Spain etc exposure without reducing their euro exposure by buying assets in stronger parts of the same monetary area. Remember what happened to bunds when peripheral yields exploded.

I don't see the problem with them hanging on " to the money for years ", it will just be recycled anyway into the UK government debt market through their banking system. On macro terms it makes no difference to the UK if no foreigners bought any gilts. Probably better for our exchange rate if they never bought any gilts. However, that would make it more difficult for the BoE to fulfill their CPI target.

What it really comes down to is foreign holders do not want the government to run excessive deficits because it exposes the foreign holder to real exchange rate risk.

Beyond the deficit and debt hysteria the people who want the government to do more to reduce the deficit do so because they do not want taxes to ride in the future. That is what it comes down to because the deficit spending today is just deferred taxation.

I didn't discuss the exchange rate issue in this post as it's already long enough, but I did mention the inflation risk from excessive issuance of money AND/OR debt, and I have explained the relationship between exchange rate, interest rates and inflation in previous posts. High inflation trashes the currency (or vice versa, depending on how you look at it). However, I will look at the whole question of exchange rate risk in a subsequent post - it's timely, given the "currency wars" we seem to be going into at the moment.

The future burden of debt has been a matter of extensive debate in the professional economics blogosphere and I didn't want to get into it here. If you are interested I wrote a slightly dorky post about the professionals' discussion which contains links to their posts:

Thanks for another interesting blog.Bit mind blowing at first and then it gets complicated! So in the absence of foreign trade there would be no necessity to issue debt? Except in so far as it controls government money creation/spending?But with foreign trade is it then ESSENTIAL to issue debt?(I realise there are currency issues but ignoring that).Or is it only required to provide the financial system with safe assets?

I said: "Debt provides a safe store of value for the citizens of the country". THAT is its main purpose. It is a savings scheme for RESIDENTS, not foreigners. There really isn't an alternative to government debt as a 100% safe long-term investment for people with more to save than the FSCS limit.

Trade is secondary, but still important since foreign residents saving currency can threaten trade liquidity. And the financial system's needs in my view come a very poor third.

To me its the framing and the word "debt" which is the problem, you said elsewhere that debunk the myth but that really is not as simple as it sounds. Trying to get that through to people is amazingly difficult.

There are huge moral and emotional connotations associated with the word "debt". That was in the back of my mind when I wrote this: if we can stop regarding government securities as "debt" and start regarding them as private sector savings, I think people might stop panicking. But it's hard work - as I discovered this evening on twitter (hence the second post!).

Your basic argument for debt seems to be that debt “provides a safe store of value for the citizens of the country.”

Assuming that by debt you mean an interest yielding government liability (in contrast to monetary base which normally pays no interest), then you don’t need debt, because monetary base provides the “safe store of value”.

As to whether savers are entitled to interest yielding securities over and above what the market left to its own devices would provide, I don’t think they are. Reason is that any such “over and above” form of saving is by defintion subsidised. That is, as you put it, government “pays interest on that debt from tax receipts..”

I don’t see why one lot of people should be forced to pay taxes to subsidise a form of saving desired by another lot. I mean it’s not as if there aren’t any pretty safe forms of saving already available: e.g. deposits at building societies (in the UK) or FDIC insured banks in the US, or TBTF banks. Granted the latter deposits are not QUITE AS safe as government debt, but the search of 100% safety is futile. I.e. I agree with you when you say “The quest for absolute safety is doomed to fail.”

I actually put a paper online a year or two ago arguing that none of the arguments for government debt stand inspection:

http://mpra.ub.uni-muenchen.de/23785/

You also seem to approve of the argument that government debt enables governments to manipulate interest rates. That’s where you say “But when the problem is too much spending and government wishes to encourage saving, government may choose to issue more debt and less money, which reduces the money stock…”. To be more accurate, even if you aren’t specifically advocating interest rate manipulation, that would the EFFECT of what you propose.

My answer to that is that interest rate manipulation is a daft way of regulating an economy, and for the very large number of reasons I gave here:

Abba Lerner and I think most MMTers go along with the latter “anti monetary policy” arguments.

Having said that, I wouldn’t totally rule out interest rate manipulation in an emergency, but you don’t need a permanent stock of government debt to do that. To illustrate, given no government debt and excessive irrational exuberance, there is nothing to stop the government / central bank machine wading into the market and paying above the going rate of interest to anyone wanting to deposit with the central bank. But that’s not “borrowing” in the normal sense of the word: i.e. inducing a lender to forgo consumption so that the borrower can consume more real resources. In the latter scenario, the central bank would simply be aiming to remove money from the private sector and temporarily shred it: do nothing with it.

That is the heart of the matter. A currency-issuing government does not need to borrow in order to cover spending gaps or bring forward consumption. It can create the money it needs. Therefore the purpose of government debt is NOT to finance the economy, as people thing. It is to provide a source of safe assets for saving. That doesn't mean that Governments can create infinite amounts of it, though - I'm not suggesting that. The total amount of debt AND money in the economy must be supported by real production and taxation.

Exactly. The money system cannot have a problem from a technical perspective in general. Money is not interested in it's 'value' in a fiat system. It's simply a promise written on 'paper' - to be in the position to exchange goods at an undefined price in the future. I am not sure if a debt chart considering inflation is correct - looking at today's purchasing power from a historic perspective.

M(r)s Fiona it's simple. The government provides money. Assuming you are in a closed system, the velocity of money is 12 and everyone spends money earned -> same money every month.

If people start saving money is missing in circulation. So the money must come from somewhere. Government prints - gap is closed.

Extend the model add interest, add government spending, consider increasing economic growth as a result and lower prices due to higher trade volumes ... agreed a very minimalistic model, imo.

If money is missing there must have been an invoice and a transaction. Printing money afterwards is never false.

The problem with this approach is another one. It can happen that the economy evolves into a Greece like system. All former unemployed people work for the state... Think of pharmacy in Mid-Europe - medicine payed by the social insurance - usually not an issue from the money perspective. But the more people work in well protected jobs financed via secondary (income) distribution the more the few left are responsible for the growth especially growth in quantity. If a country is dependent on exports international competition is hurting those too. The percentage financed via the remaining few can simply be measured in

(cost for work - net income + corporate taxes) = amount redistributed. Add taxes/fees included into products. Indirectly financed part of the economy. Not considering interest in products, assuming no savings.

The whole story becomes a lot more sophisticated when we consider: Income from savings, government's interest payments, savings in general, interest included into products.

If a government is not in the position to print money the economy is facing the situation similar to the Euro Region. In this case the interest the government has to pay does not stay in the economy or cannot be reinvested directly. The special situation with global companies financed by global 'banks'/investors. This adds complexity as well as the whole transfer story. Global - Euro Region - Local Economy - ...

I take your point about sovereign debt being a "safe store of value" for a country's citizens; I assume you a referring to those people who invest via insurance & pension funds which purchase issued gilts. Surely any "safety" aspect, i.e. capital & coupon guarantees, is derived from the government being able to tax actual economic output which has measurable and genuinely reliable value rather than simply the proceeds of monetization that can devalue the currency. If that is the case then won't anyone who is both a saver & a taxpayer be, in essence, providing their own pension investment return from the tax levied from their own earned income? Is that financially any different to a parent taking money from their savings account to lend to their offspring so the latter can buy a car but the only means for the offspring to pay back the amount borrowed + interest is their monthly allowance from the parent rather than any earned income of their own?

Your arguments appear to rest on taxation as the ultimate backstop. For example Japan where the huge level of Gvt debt is held by residents who can be taxed to cover the cost of servicing this debt. Doesn't this overlook the significant adverse social, political and economic effects were taxation to be used in this way? In Japan this would imply huge increases in domestic taxation, with distributional issues since this burden clearly would not fall neatly and precisely on those holding the government's bonds (and if it did, it would prompt flight into other forms of saving).

If - in practice rather than principle - it is not realistic ever to expect taxation to be used in this way, it seems to me that our argument about the nature of government debt starts to unravel?

You are right that taxation is critical, though I don't agree that huge increases in tax would necessarily be necessary. I did follow this post up with another one that addressed the question of taxation - it's a bit of a rant, I'm afraid:

http://coppolacomment.blogspot.co.uk/2013/01/so-whats-catch.html

There is a very interesting further debate on the role of taxation in the comments on that post.

Very interesting. but maybe not for obvious reasons. it deeply disturbs me that there is a wide misunderstanding of such a fundamental issue. either by you, me or the public. how is it that there is enough ignorance of how the value of our labour is stored and accounted for that you can make a convincing argument for or against your position without a decisive revealing of truth which will give direction for our society.it is interesting also that the recurring themes of value, store of value and liquidity keep cropping up in economic debate when these fundamental issues should be widely known for all to understand.i personnaly think that current value is dictated by perceived future value and that the world is going through a multi-generational energy/resource/demographic shift which changes future valuations and the perception of stores of value and that there are liquidity issues generated by transfers of funds linked to this shift.given the huge numbers, valuations and forces at work i think it unlikely that this shift will be silky smooth...

for disclosure (i am a gold bug but not a gold standard proponent. i would propose different mixes of stores of value and mediums of exchange for different national situations which usually would result in a commodity basket linked currency hybridised with the current system. involving a balance of power between central banks and treasuries based on logical and widely understood criteria which would be flexible but curtailed by the balance of powers and transparent.)

p.s i hope my verbosity does not hinder understanding and if it does that at least it may cover up possible lack of knowledge on my part!

Very lucidly explained to someone who was genuinely freaked out by - and is still reading your expose of (but took a linked diversion to this page) - MoneyWeek's End of Britain. Thanks for enlightening!

About Me

In a past life I worked for banks...now I write about them. Actually I write about finance and economics generally. And about anything else that interests me - so you may occasionally find posts on this site that have nothing to do with banking, economics or finance. In fact they might have something to do with music, since I'm a Associate of the Royal College of Music and a professional singer and teacher. I'm also an alumnus of Cass Business School, where I did an MBA with a specialism in finance and risk management.
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